Fed’s decision to hold rate could complicate Canadian recovery

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In a matter of months, the U.S. Federal Reserve has gone from revving up its rate-hiking machine to what now looks like an extended idle.

The shift presents some untimely complications for Canada's own economic recovery – unless the U.S. job market can ride to the rescue.

The Fed's latest rate decision, issued on Wednesday afternoon, was, frankly, about as dull as such things get.

To no one's surprise, the central bank left its key federal funds rate unchanged, at a range of 0.25 per cent to 0.5 per cent. To no one's surprise, it acknowledged what anyone who has watched the disappointing economic data of the past couple of months could have told you: "Growth in economic activity appears to have slowed."

Fed watchers scoured for clues as to whether the U.S. central bank was any closer to another rate increase. A few said "yes," pointing out that the Fed dropped from the statement its concern from the previous rate decision, in March, that "global economic and financial developments continue to pose risks." A few said "no," noting that unlike in the run-up to the December rate increase, the Fed did not indicate a rate increase would be on the table for its next meeting – nor, indeed, did it indicate it is leaning toward a rate hike in the foreseeable future at all. Markets mostly just shrugged and moved on, concluding that there was nothing to see here.

Last December, when the Fed confidently raised its rate for the first time in nearly a decade, it seemed clear to pretty much everyone that the Fed would follow that up with more rate increases in 2016 – indeed, probably several of them. There were questions about how many and how much, but few doubted they were imminent. Now, it looks like at the very least, the first half of the year will see no increases at all.

The rise of the current more cautious tone recognizes that the U.S. economy has been sluggish for several months now and is showing few signs of shaking its funk. The ongoing stream of tepid U.S. economic data – on manufacturing, retail sales, housing, trade – reinforces concerns about the fragility of U.S. demand. The pace of the U.S. recovery, which seemed so certain last fall, has come into question.

That, by extension, raises questions about Canada's recovery. Despite a strong start to 2016, there's little question that the sustainability of Canadian growth is highly dependent on continued expansion of its non-energy exports. A healthy U.S. economy, which consumes three-quarters of Canada's total exports, is absolutely essential.

The most troubling indicator of the U.S. economic malaise, from a Canadian perspective, came just hours before the Fed decision, in the preliminary March trade data. U.S. imports slumped 4.3 per cent month over month, with the declines coming pretty much across the board. For the first three months of the year, imports into the United States were down nearly 5 per cent compared with the same period in 2015 – and remember, that year-earlier quarter was one in which the U.S. economy barely grew at all. Those numbers don't say much for U.S. demand for imported goods and that's troubling for Canadian exporters.

What's more, with the sputtering economy pushing expectations of another Fed interest-rate increase further into the distance, that should put some downward pressure on the U.S. dollar and (correspondingly) upward pressure on the Canadian dollar, especially given that the Bank of Canada's own outlook has been on the upswing. The Canadian dollar has already risen sharply this year, a move the Bank of Canada has linked largely to the recovery in oil prices, but the faltering U.S. rate prospects have certainly become an element in that story. Further gains would threaten to put an additional dent in export growth.

The key hope to put everything back on a healthier track – for U.S. growth and the rate outlook and, by extension, Canada's export-led recovery – may lie in the U.S. labour market. Indeed, the Fed may have sent that signal in its rate announcement.

Conspicuously, the Fed noted in the first sentence of the statement that "labour market conditions have improved" in spite of the growth slowdown. Only a few lines lower, it essentially repeated that assertion. Even as economic growth has hit the pause button, employment has risen by a brisk 460,000 net new jobs in the past two months; the unemployment rate is near an eight-year low.

It's a timely reminder that the Fed's rate policy is tied to a dual mandate of both maximum employment and stable inflation. Its emphasis on the jobs side of that equation may signal that if the U.S. economy can keep cranking out jobs, that might outweigh some nagging concerns about slack growth and a lack of inflation pressures.

The Fed noted that the strong labour market is pushing up household incomes "at a solid rate." In short, a strong labour market may cure whatever else ails the U.S. economy at the moment – and could be the key to seeing Fed rate increases return to the radar screen in the second half of the year.